Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

While preparing for a recent keynote speech about stable value fund risk management, I took a dinner break at a local Chinese restaurant. After a satisfying meal, I reached for the fortune cookie. Lo and behold, the message eerily resembled the nature of my talk that was scheduled for the following day.

"All things have a cause. Look into your past for answers."

While I am not a big believer in relying on historical performance numbers as a bellwether for future returns, it is reasonable to question what went wrong n the last few years. Indeed, lessons learned about risk management failures and how investors should better protect themselves going forward are sunny spots in an otherwise gloomy economic climate.

Here are a few of my favorite strolls down memory lane with hopes that organizations will use the rout of the last several years to improve their existing oversight structure and risk controls.

• Numbers are only as good as the inputs and assumptions used to create them. Additionally, risk management goes well beyond numbers. How many hedge funds had terrific Sharpe Ratios in 2008 and 2009 but lousy operational or financial stop-loss points?
• Use independent third party vendors to kick the tires on mark-to-market or mark-to-model numbers for hard-to-value positions. U.S. and non-U.S. regulators have been none too shy about making their concerns about the integrity of valuation reports, indicating that statutory mandates are coming our way in short order. 
• Ask questions if performance appears too steady or too robust. Unless an asset manager is artificially smoothing out returns, investors should expect some bumps along the way. No one gets the trades right all the time.
• Institutional investors should ask to meet with an asset manager's Chief Risk Officer, demand to read the fund manager's risk management policy statement and understand how traders are compensated. The goal is to avoid investing with cowboy (or cowgirl) traders who are motivated to take unnecessary risks because their bonuses are tied to inflated performance numbers.
• Ask about how leverage is measured and managed. The use of other people's money, whether through borrowing, short selling, margin transacting and/or use of derivatives, has pros and cons. In bad times, leverage is your worst enemy because it magnifies losses. Moreover, a highly levered position(s) could force cash outlays at a time when available cash is limited and the ability to borrow more money is nigh impossible or extremely costly.
• Banish the term "risk-free" from your investment lexicon. Nothing is risk-free. Even putting money under one's mattress is risky if the house goes on fire. Countless investment vehicles have been touted as "low risk." Expect unhappy investors to seek redress from asset managers, advisors and consultants if performance is negative or sub-par. The tolerance level for sloppy risk management, post Madoff, is low.

Future posts will discuss other aspects of investment best practices and financial "no no's." In the meantime, early February 2011 marks the Year of the Rabbit and a time for caution about investing. Embracing an enterprise risk management focus is sure to go a long way towards calming a fear of the unknown.